Tax Benefits Of Pension Schemes And Stock Investments You Need To Know
Key Takeaways
A pension plan is a great investment option as it looks out for the future and, while doing that, also provides some benefits in the form of tax relief. Pension plans in India may invest in stocks through various mechanisms, depending on the type of plan.
Here's a detailed explanation of how pension plans invest in the capital market including stocks, how it works, and how capital gains tax applies along with the tax benefits for pension plans.
Maximising Tax Savings with NPS and Pension Schemes
The National Pension System (NPS) and various pension schemes offer powerful tax benefits that can reduce your taxable income while securing your financial future.
National Pension System (NPS)
The NPS is a government-backed retirement savings scheme open to all citizens between 18 and 70. The two account types under NPS are Tier I, which is mandatory and non-withdrawable until retirement; and Tier II which is voluntary and withdrawable anytime.
NPS offers a choice of investment in various asset classes including equity (E), corporate bonds (C), alternative investment funds (A), and government securities (G). Up to 75% of the contributions can be allocated to equity funds, which invest in stocks.
This option is suitable for those with a higher risk appetite and a longer investment horizon. Corporate Bonds (C) are investments in high-rated corporate bonds and government securities are investments in government bonds and securities.
Alternative investment funds include investments in infrastructure and real estate and are limited to 5% of the contributions.
Understanding the Tax Benefits of NPS for Retirement
NPS allows for partial withdrawal of up to 60% of the corpus at retirement, which is tax-free. The remaining 40% must be used to purchase an annuity, which is also tax-exempt. However, any gains from the investment of the corpus are subject to capital gains tax.
Contributions to NPS are eligible for tax deductions under Section 80C and an additional deduction under Section 80CCD(1B) up to ₹50,000.
Unit Linked Insurance Plans (ULIPs)
ULIPs allow policyholders to invest in various funds, including equity funds, which invest in stocks while enjoying a life cover. The policyholder can choose the proportion of investment in equity, debt or balanced funds.
ULIPs allow policyholders to switch between different funds based on market conditions and their risk appetite. This flexibility helps in optimising returns.
Investment Focus and Taxability of ULIPs
ULIPs provide a combination of insurance and investment. Policyholders can choose from various options:
ULIPs are subject to long-term capital gains tax (LTCG) if the annual premium exceeds ₹2.5 lakh. Gains above ₹1.5 lakh are taxed at 12.5% without the benefit of indexation.
Premiums paid are eligible for tax deductions under Section 80C and the maturity proceeds are tax-free under Section 10 (10D) if the premium does not exceed 10% of the sum assured.
Employee Provident Fund (EPF)
The EPFO which manages EPF invests a portion of the corpus in equities through Exchange Traded Funds (ETFs). Currently, up to 15% of the incremental corpus is invested in ETFs that track stock market indices like the Nifty 50 and Sensex. This exposure to equities aims to enhance returns while maintaining a conservative investment approach.
EPF is a retirement benefit scheme for salaried employees. It’s mandatory for employees earning above ₹15,000 per month, with both the employer and employee contributing 12% of the employee's basic salary and dearness allowance to the fund.
Partial withdrawals are allowed at any given time, however, these withdrawals are only tax free under certain conditions and for specific purposes like marriage, education, medical emergencies, etc.
The EPF is also exempt from capital gains tax. There is no tax on pension lump sum maturity proceeds including the interest earned, provided the employee has completed five years of continuous service. The contributions made to the EPF are eligible for tax deductions under Section 80C.
Traditional Pension Plans
Traditional pension plans typically do not invest directly in stocks. They focus on providing guaranteed returns through investments in debt instruments and government securities. These plans are suitable for risk-averse investors looking for stable and predictable returns.
Traditional Pension Plans provide a fixed return as a steady income post-retirement as regular payouts. The maturity proceeds from traditional pension plans are generally exempt from capital gains tax under Section 10(10D). This provided the premium does not exceed 10% of the sum assured. Premiums paid are eligible for tax deductions under Section 80C.
Senior Citizens Savings Scheme (SCSS)
This does not invest in stocks. It is a government-backed scheme that invests in government securities and fixed-income instruments, offering a safe and secure investment option for senior citizens.
It is for all Indian citizens aged 60 and above. Currently it pays an interest of 8.2% per annum which is payable quarterly. The tenure of the scheme is 5 years, however, it is extendable by 3 years.
The interest earned from SCSS is taxable as per the individual's income tax slab and there is no capital gains tax on the maturity amount. The contributions are eligible for tax deductions under Section 80C.
Risk, Returns and Diversification
Equity investments in pension plans like NPS and ULIPs offer the potential for higher returns but come with higher risk compared to debt investments. Pension plans often diversify investments across various asset classes, including equities, to balance risk and returns.
These mechanisms allow pension plans to leverage the growth potential of the stock market while managing risk through diversification and professional fund management. Fund managers with expertise in managing investments handle the equity allocations, aiming to maximise returns while managing risks.
Capital Gains Tax on Pension Plans
Gains from assets held for less than 36 months are considered short-term and are taxed at the individual's income tax slab rate. However, the gains from assets held for more than 36 months are considered long-term and are taxed at 12.5% without the benefit of indexation for gains exceeding ₹1.25 lakh.
How Pension Plans Offer Tax Benefits for Retirement Savings
In many cases contributions made to pension plans are deductible under Section 80C. Additionally, the sections of the income tax act which provide exemptions to pension plans from capital gains tax are:
These tax benefits on pension plans can vary based on specific conditions and changes in tax laws. It is always a good idea to consulting with a financial advisor or tax expert for personalised advice.
Frequently Asked Questions
1. How do pension plans offer tax benefits?
You need to pay tax for the pension you receive from an annuity life insurance plan. However, you can claim a tax deduction of up to ₹1.5 lakh per year on the premiums you pay under Section 80C and Section 80CCE. You can claim a maximum tax deduction of ₹1.5 lakh per year on the premiums. This falls under Section 80C and Section 80CCE.
2. What are the tax advantages of stock market investments?
The Rajiv Gandhi Equity Savings Scheme (RGESS), introduced in 2012, promotes first-time investors to join the stock market. Investors whose income is up to ₹12 lakh per annum can claim a 50% tax deduction. They can save up to ₹50,000 under Section 80CCG. They can benefit from this for three years.
3. Can I claim tax benefits on my NPS contributions?
Anyone can consider investing in the National Pension Scheme and plan for their retirement beforehand with low-risk factors. You can get tax benefits like:
For Employees (Self-Contribution)
Self-employed individuals can get benefits like:
4. What tax is applicable on pension lump-sum payments?
Pension lump-sum payments or commuted pensions, have different tax treatments:
5. How do tax-advantaged retirement accounts interact with stock investments?
In India, tax-advantaged retirement accounts interact with stock investments are:
6. What are the tax exemptions available for pension schemes?
Tax deduction available under Section 80CCC. With this you can deduct up to ₹1.5 lakh per financial year. This deduction is for contributions to pension plans from life insurance companies. It shares the ₹1.5 lakh limit with Section 80C and Section 80CCD(1).
7. How can I reduce taxes on stock market gains?
You can reduce your tax liability under Section 54EC. With this, you can reinvest your long-term capital gains into bonds to get a tax exemption. The maximum limit is ₹50 lakh per financial year.